If there is only one Canadian tax development for 2012 that
foreign readers should be aware of, it is certainly the pending
enactment of sweeping new rules directed at foreign-controlled
Canadian resident corporations known colloquially as the
"foreign affiliate dumping" rules (the FAD rules). While
motivated by legitimate tax policy concerns, the FAD rules cast an
overly broad net that goes far beyond the original mischief
motivating their creation, and encompass many transactions that
simply should not be caught. As such, the FAD rules are likely to
create unpleasant surprises for taxpayers who are unaware of these
rules, are unable or unwilling to spend the resources required to
carefully work through them, or ignore them on the mistaken (but
understandable) premise that these rules won't apply to
taxpayers who are neither seeking nor obtaining any Canadian tax
advantage or benefit.

For some years the Department of Finance has been troubled by
transactions that, in their simplest form, involve a Canadian
subsidiary of a foreign multinational group incurring intragroup
debt to purchase shares (often fixed-value shares) of a foreign
group member. Such "debt dumping" allowed the Canadian
subsidiary to use the interest expense deduction on that debt to
reduce Canadian tax payable, while creating little or no income
that would be taxable in Canada, given that Canada's foreign
affiliate rules largely exempt from Canadian taxation distributions
received by a Canadian corporation from a corporation resident (and
carrying on an active business) in a jurisdiction with which Canada
has a tax treaty or tax information exchange agreement.1
Effectively Canada perceived its foreign affiliate regime and
interest deductibility rules as being misused when interest expense
arising from investments in foreign affiliates that had been
"dumped" into Canada by their foreign parent reduced
Canadian tax on Canadian-source income.2

The FAD rules go far beyond this relatively narrow (and
legitimate) concern. Rather than simply limiting interest expense
deductions, these rules effectively treat almost any transfer of
property (or incurrence of a liability) by a foreign-controlled
Canadian corporation as prima facie surplus stripping designed to
sidestep dividend withholding tax, to the extent that it relates to
a foreign affiliate of the Canadian corporation. As such, when
applicable, the FAD rules often produce a deemed dividend subject
to Canadian withholding tax, either immediately or in the future,
even when the transaction in question is a value-for-value exchange
resulting in no net extraction of assets from Canada.

Needless planning/compliance costs created for taxpayers without
corresponding benefits to Canada. Treating investments
"down" the chain as equivalent to distributions
"up" and out of Canada contrary to existing tax policy
and resulting in double taxation.

Will reduce the attractiveness of Canadian corporations to
foreign buyers (particularly negative impact on mining sector,
where is Canada commonly used as a base for foreign projects), and
by extension to foreign investors choosing where to locate new
holding/headquarters companies, since eventual takeover is exit
strategy.

Foreign multinationals discouraged from holding/managing foreign
subsidiaries through Canadian corporations.

Those responsible for designing and implementing tax policy at
the Department of Finance do not have an easy job, and this
relatively small group of dedicated public servants does a huge
amount of work. It is difficult to achieve the right balance among
the goals of raising the revenue that Canada needs, protecting the
tax base from erosion, ensuring that compliance costs for taxpayers
are kept to the minimum necessary for the proper functioning of the
tax system, and encouraging (or at least not impeding) economic
activity from which Canada benefits. Reasonable people can differ
as to the choices that are made among these goals. That said, the
FAD rules simply put too much emphasis on preventing base erosion,
and all or substantially all of that objective could have been
achieved with a more focused rule that would not create the undue
tax costs and compliance/planning burden generated by the FAD rules
or cause foreign groups and investors to reduce the economic
activity they undertake in Canada, which is already occurring. The
concerns with the FAD rules are summarized in Figure 1.

Originally announced in the federal budget of March 29,
2012,3 the FAD rules target Canadian resident
corporations that are controlled by a foreign corporation and make
"investments" in non-Canadian corporations (including the
mere conferral of "benefits" on those foreign entities).
When applicable, the FAD rules deem the Canadian resident
corporation to have paid a dividend to the foreign parent
corporation (triggering nonresident dividend withholding tax) or
reduce the Canadian resident corporation's tax attributes,
adversely affecting it in various ways. While the FAD rules include
provisions that exclude or mitigate the effect of their application
in some circumstances, these provisions are too narrowly drafted,
too complicated in their operation, and insufficiently workable in
practice to offset the adverse effects of the overbroad charging
provision.

Figure 2. Canco Capital Contribution

In August 2012 the government released draft legislation setting
out the FAD rules, which was followed by a further version in
October 2012.4 While the later versions include some
very meaningful improvements over the initial proposals, they also
take a significant step backwards in some areas. In particular, the
FAD rules are overly broad and capture many situations and produce
many results that they should not, even after taking into account
their relieving provisions. The combination of their breadth, their
complexity, and the nonintuitive results they can produce make them
particularly easy to run afoul of inadvertently. They constitute a
dramatic shift in tax policy in the Income Tax Act (Canada), indeed
going beyond the objectives stated by the government in enacting
them.

By way of a simple example, when a foreign-controlled Canadian
corporation contributes money to the capital of a wholly owned
foreign subsidiary, the FAD rules treat this as prima facie
equivalent to a dividend paid by the Canadian corporation to its
foreign parent, and Canadian dividend withholding tax at a rate of
5 to 25 percent (depending on the facts) applies. (See Figure 2.)
Moreover, there is no offsetting increase in the Canadian
corporation's tax attributes, meaning that if the same money
(or other property) is subsequently distributed by the Canadian
corporation as an actual dividend, Canadian withholding tax will
apply again, resulting in double taxation. An observer can be
forgiven for finding this result to be something less than
intuitive. While in some instances the FAD rules may allow such a
deemed dividend to instead be treated as a reduction of the
Canadian corporation's existing tax attributes (which also has
adverse implications) to the extent such attributes exist, and in
some circumstances a reduction of tax attributes occurring under
the FAD rules may be reversed for limited purposes, the point is
that this type of innocuous transaction is caught within the FAD
rules, and the taxpayer is then left searching for an exception to
their application (of which there are few) or a relieving provision
that mitigates their effect.

Treating a payment "down" the chain to a wholly owned
subsidiary "below" Canada (and hence completely within
Canada's system for taxing foreign affiliates of Canadian
corporations) as the equivalent of a distribution "up"
the chain to a shareholder "above" Canada (that is,
outside the Canadian tax system) is simply unprecedented and
constitutes a major shift in Canada's international tax policy.
The ITA recognizes that a Canadian corporation's foreign
affiliates (or controlled foreign affiliates) remain within the
Canadian tax system and accordingly it differentiates between the
Canadian corporation's transactions with such foreign entities
and its transactions with other nonresidents of Canada.5
However, the FAD rules ignore this principle for Canadian
corporations that are foreign-controlled, effectively treating them
as prima facie eroding the Canadian tax base by recharacterizing
their transactions "down" the chain with foreign
affiliates as distributions "up" the chain and out of
Canada unless they fall within a narrow list of permitted
exclusions or relieving provisions. This is a sub-optimal tax
policy choice.

While the FAD rules are quite complex, at a very high level the
process for working through them can be summarized as follows:

determine whether the charging provision applies to the
transaction;

if so, consider whether the "investment" is excluded
by virtue of one of the limited exceptions provided for in the FAD
rules; and

if no exception applies, determine the consequences of the
rules' application.

I. SCOPE OF THE FAD RULES

The FAD rules set out a charging provision that is fairly simple
to express, although not necessarily to interpret. It applies when
a corporation that is resident in Canada (Canco) and that is
controlled by a nonresident corporation (Parent)6 makes
an investment in a corporation not resident in Canada (Foreignco)
that is a foreign affiliate of Canco.7 For this purpose,
an investment includes an acquisition of debt of
Foreignco8 and shares of Foreignco. The range
of transactions caught by these rules is then broadened as
follows:

Benefit Conferred on
Foreignco: A contribution by Canco
to the capital of Foreignco is treated as an
"investment," which for this purpose is deemed to include
any benefit conferred by Canco on Foreignco.

Options or
Interests: The acquisition by Canco
of an option regarding, or an interest in, any Foreignco shares or
debt9 is deemed to be an investment.

Maturity/Redemption Date
Extensions: If the maturity date of
a debt owing by Foreignco to Canco (other than a "pertinent
debt" described in Section III below) or the redemption date
of Foreignco shares owned by Canco is extended, the extension is
treated as an acquisition of such debt or shares.

Indirect
Acquisitions: If Canco acquires
shares of another Canadian corporation more than 75 percent of the
value of whose assets is attributable to shares the other Canadian
corporation owns (directly or indirectly) in its foreign
affiliates, this too is caught as an indirect acquisition of the
shares of those foreign affiliates (herein, an "indirect
acquisition"; see Figure 3). Another rule further extends the
net to cases in which property of the acquired Canadian corporation
is later sold as part of the series of transactions that includes
Canco's investment (the relevant series) and such sale results
in the ">75 percent attributable" threshold being met
at any time during the relevant series.

Relevant Series of
Transactions: The charging rule
extends to situations in which it would otherwise not apply because
Foreignco is not a foreign affiliate of Canco or Canco is not
controlled by Parent at the time of the Canco's investment, but
at some other time during the relevant series, Foreignco
becomes a foreign affiliate of Canco or Canco
becomes controlled by Parent.

Acquisitions by
Partnerships: Look-through rules
attribute acquisitions made by a partnership to its partners.

A few narrowly drafted exceptions are carved out of the FAD
rules. As discussed in Section III below, in the case of an
acquisition of Foreignco debt by Canco, there are
exclusions for:

debt incurred in the ordinary course of business (for example,
trade debt) and repaid within 180 days; and

debt arising after March 28, 2012, that Canco elects to make
subject to a new rule requiring the inclusion in its income of at
least a minimum amount of interest.

An exception is also provided for Canco acquisitions of
Foreignco shares as part of some (but not all) intragroup
corporate reorganizations (discussed in Section IV below). A
smaller number of corporate reorganization exemptions apply to
indirect acquisitions, that is, acquisitions of shares of another
Canadian corporation passing the ">75 percent
attributable" threshold. A further exception meant to allow
for investments in foreign affiliates made as part of a strategic
business expansion (discussed in Section V below) is so narrowly
drafted and unclear in scope as to be of little practical use in
all but a handful of cases. Figure 4 summarizes the analysis for
assessing whether the FAD rules apply.

A. Consequences of Application

When the FAD rules apply to Canco's investment, they
potentially have two effects:

Figure 3. Indirect Acquisition Rule (Takeover)

To the extent that in relation to its investment Canco has
transferred any property (other than Canco shares), incurred any
obligation or received any property reducing an amount owing to it,
the value thereof is treated as a dividend paid by Canco to Parent,
triggering Canadian dividend withholding tax at a rate of 25
percent (subject to treaty reduction). Thus, for example, Canco
making a loan to Foreignco or paying the purchase price for
Foreignco shares in cash or a promissory note is treated as a
dividend, even when Canco is acquiring property of equal value and
even if the seller is an arm's-length party.

To the extent that Canco has increased the paid-up capital
(PUC) of its shares in relation to the investment (such as by
issuing new Canco shares), that increase is reversed. This
suppression of PUC reduces the amount Canco can distribute to
nonresident shareholders as a return of invested capital without
those shareholders incurring no-nresident dividend withholding
tax,10 and so effectively amounts to a deferral of the
deemed dividend rather than its elimination (subject to the
potential PUC reinstatement described below). Moreover, suppressing
Canco's PUC limits Canco's ability to deduct interest
expense on intragroup debt owing to nonresidents of Canada under
Canada's thin capitalization rules.11

There are then three further rules that may or may not mitigate
the adverse effects of the FAD rules applying (depending on the
facts), as discussed in Section VI:

In some cases, an election may be made to treat a dividend that
would otherwise be deemed to have been paid by Canco to instead be
paid by another related Canadian resident corporation (a qualifying
substitute corporation, or QSC), if this would produce a less
disadvantageous result (for example, a treaty-reduced dividend
withholding tax rate lower than the rate applicable to a dividend
deemed to be paid by Canco to Parent).

Figure 4. Foreign Affiliate Dumping Rules: Application

In some cases, some or all of a deemed dividend (including one
resulting from a QSC election) is replaced with a reduction in the
PUC of the shares of Canco (or a QSC). While typically preferable
to an immediate deemed dividend, such a PUC reduction has both
immediate and future adverse effects and so constitutes only
partial relief.

When PUC has been reduced under the FAD rules, in some
circumstances the PUC so reduced can be reinstated solely for the
purpose of distributing out of Canco (or the QSC) any Foreignco
shares Canco's investment in respect of which triggered the
application of the FAD rules, any shares of another foreign
affiliate substituted for those Foreignco shares, or sale proceeds
from or distributions received on such shares.12

Effectively, the FAD rules treat any investment by a
foreign-controlled Canadian corporation relating to a foreign
affiliate as either:

a deemed return of capital distribution (causing future Canco
distributions to trigger dividend withholding tax and reducing
Canco's ability to debt-finance from foreign group members in
the interim), unless:

the investment is a debt owing by Foreignco that either bears a
sufficiently high rate of interest or is a short-term trade
payable;

the investment occurs on a permitted intragroup corporate
reorganization that does not amount to an incremental investment
outside of Canada by Canco; or

the investment occurs within the narrow confines of a complex
and unworkable exception requiring that:

the business activities of Foreignco and its subsidiaries be
"more closely connected" with the business activities in
Canada of Canco (or related Cancos) than with the business
activities of other non-Canadian group members; and

Canco officers (a majority of whom are resident and working in
Canada or certain other countries) have and maintain principal
control over the investment in Foreignco.13

If the investment is one to which the FAD rules apply initially
to reduce Canco's PUC (as opposed to deeming a dividend to
occur), and if subsequent events cause such PUC reduction to be
reversed under the PUC reinstatement rule described in Section VI
solely for the purpose of allowing Canco to emigrate from Canada or
make certain distributions out of Canada, the initial PUC reduction
should not result in double taxation.

II. PROBLEMS WITH THE GENERAL RULE

As described earlier, the main problem with the FAD rules is
that the charging provision is simply too broad and captures far
more than it should. While a few exceptions and alleviating
mechanisms are provided in the rules, they are narrowly drafted and
substantively inadequate to fix a charging provision that needs to
be more precise and more focused on what the policy concern is.
There simply is not an appropriate degree of linkage between when
the rules apply and the tax results they seek to prevent. The
government's objective in enacting the FAD rules is stated to
be countering erosion of the Canadian tax base arising from:

the exemption from Canadian taxation of most foreign affiliate
dividends in combination with the deductibility of interest expense
incurred to make investments in foreign affiliates; and

the extraction of corporate surplus from Canada free of
dividend withholding tax.14

The following are significant ways in which the charging
provision as drafted (and even after taking the exceptions and
alleviating provisions into account) overreaches this
objective:

It applies regardless of whether Canco's investment
produces any deductions from income (interest expense or otherwise)
in Canada.

It can apply even when Canco's investment produces (or
could produce) income that would be taxable in Canada (that is,
something other than distributions from a foreign affiliate that
benefit from a 100 percent dividends-received
deduction).15

It deems Canco to have made distributions even when no net
assets have been extracted from Canada, for example, when Canco has
participated in a value-for-value transaction, which is difficult
to reconcile with the stated objective of preventing the extraction
of corporate surplus. In fact, its application does not depend on
the existence of any Canco corporate surplus, an odd
feature of rules stated to be directed at preventing the tax-free
extraction of such.

It applies without regard to whether the investment has any
Canadian tax purpose (or achieves any Canadian tax advantage),
which is particularly troubling since the business purpose test in
the original proposed version of the FAD rules was the primary
filter for preventing that version of these rules from applying to
transactions that should not be caught. The result is that the FAD
rules may impede, for example, the legitimate diversification of
the business activities of Canco's foreign affiliates.

It can clearly apply in many instances to create double
taxation, as is discussed further below. For example, double
taxation will frequently occur whenever the FAD rules apply to deem
a dividend to have been paid or deem a PUC reduction to occur that
is not subsequently reversed under the rule allowing PUC
reinstatement in limited circumstances.

As noted earlier, it does not meaningfully differentiate
between Canco investments made "down" the chain to
closely controlled foreign affiliates (including those completely
under Canadian ownership), and other investments made above Canco
or outside the cone of Canco and its closely controlled foreign
affiliates, contrary to established tax policy elsewhere in the
ITA. In the context of preventing surplus stripping, these are
simply not equivalent situations, since the former remain within
Canada's system for taxing controlled foreign affiliates and
any related corporate surplus remains in or below
Canco.16

It does not differentiate between investment transactions with
arm's-length third parties (which are much less likely to
involve base erosion) and intragroup transactions (which were the
original source of the avoidance prompting the government to
act).17

A Canco that has arm's-length minority shareholders or that
is a public corporation is treated the same as a Canco that is a
wholly owned subsidiary of a multinational group, even though
Canadian corporate law generally prevents Canco from unfairly
favoring the controlling shareholder over minority shareholders,
and a public corporation would be seriously constrained under
Canadian corporate and securities laws from engaging in
substantially all of the tax-motivated transactions that the FAD
rules are directed at.

Treating the conferral of benefits on a foreign affiliate
(guaranteeing debts, providing management and related services,
legal and accounting advice, and so forth) as an investment is
quite impractical, and is something better left to transfer pricing
rules rather than rules treating the conferral of such benefits as
deemed dividends triggering immediate taxation.

As is discussed below, the extension of the FAD rules to
include indirect investments (acquisitions of shares of Canadian
corporations more than 75 percent of whose property consists of
shares of foreign affiliates) is especially unfortunate and will
have a number of adverse effects.

The use of the series of transactions concept to expand the
reach of the charging rule is especially objectionable, given the
broad and uncertain scope of that term, as is discussed below.
There is no apparent justification for applying the FAD rules
whenever Canco becomes controlled by Parent or Foreignco
becomes a foreign affiliate of Canco as part of the same
series of transactions as the investment (possibly occurring years
apart), given how tenuous a connection is required between the two
events in order for them to constitute part of the same series of
transactions.

The lack of any differentiation in the charging provision
between investments in Foreigncos that were already Canco foreign
affiliates on March 28, 2012, and investments in new foreign
affiliates unfairly prejudices foreign groups that have inherited
Canadian foreign affiliates following the acquisition of a Canco or
that have made Canada a regional headquarters or product center for
perfectly valid business reasons.

The approach taken in the FAD rules is to ensure that virtually
every possible objectionable transaction is caught, and then rely
on some very limited and inadequate relieving provisions to prevent
inappropriate results, or simply assume that taxpayers will plan
their arrangements so as to steer a very wide berth around the FAD
rules. This is unfortunate, as there are significant detriments to
having a charging provision that is too broad and captures more
than it should:

It clearly makes the FAD rules more complex than they need to
be to achieve their objectives.

It makes foreign investors more apprehensive about change of
law risk in Canada, that is, the likelihood that there will be
further adverse changes in Canadian tax law in the future affecting
foreign investments made through Canada.

It greatly increases the planning and compliance costs for
taxpayers beyond what they should be, without generating any
significant benefits. It is not appropriate to draft tax
legislation on the assumption that all taxpayers will be aware of,
and will have the time and resources to plan around, the
overbreadth of the charging provision (to the limited extent such
is possible).

Ultimately, it makes Canada less attractive than it otherwise
would be for foreign investors who have a choice between using
Canada or another jurisdiction as a base for managing foreign
operations, potentially diverting away economic activity that would
otherwise occur in and benefit Canada.

A prime example of the last point is the Canadian mining
industry. Canada possesses a world-leading infrastructure of
geologists, lawyers, accountants, bankers, and financiers with
mining sector expertise, well-known and accepted corporate law,
stock exchanges (TSX and TSX-V) that have more mining listings than
any other in the world,18 and the world's most
stable banking system.19 These have contributed to make
Canada the center of the world's mining industry, and Canadian
corporations are frequently used as head office entities for mining
projects in Latin America, Africa, Asia, or elsewhere in the
world.

Investors deciding where to set up mining companies generally
presume that using Canada in this way will be tax-neutral, since
they have no material Canadian-source income, aren't seeking to
generate any tax deductions or advantages in Canada, and typically
view the sale of the Canadian company itself as the most likely
exit strategy. As such, they start from the presumption that they
will not have material Canadian tax issues when choosing to use a
Canadian holding company for foreign investments, and to date they
have generally been correct. The FAD rules change this paradigm,
and the danger is that such investors will not be aware of how
broad these rules are or (if they are) have any willingness to
expend time and resources planning around them: They will simply go
elsewhere.

The risk to Canada is the erosion of its dominant position in
the mining sector, through the unintended creation of a tax issue
that causes foreign investors to locate elsewhere high-value
economic activity that:

would otherwise occur in Canada; and

does not constitute the kind of inappropriate tax planning that
the FAD rules are directed at.

Most foreign investors undertaking projects that could be, but
need not be, headquartered in Canada (especially junior mining
companies with very limited management and financial resources)
simply will not spend time or money to deal with complicated rules
that do or may apply but possibly can be managed around in the
right circumstances.

The government's view appears to be that potentially
affected taxpayers will be aware of the scope of these rules, and
either expend the resources required to plan their way through them
or simply steer far wide of them by not involving Canadian
corporations in foreign activities. In many cases the latter will
be the more likely result, with a significant loss of economic
activity (in mining and other sectors) that would otherwise be of
benefit to Canada. This will potentially manifest itself in
numerous ways:

As noted above, foreign investors looking for a suitable
holding company jurisdiction as a base for foreign projects (as
often occurs in the natural resources sector) may choose a country
that does not involve any risk of double taxation or require any
significant tax planning or compliance to be tax-neutral, and that
is perceived as having less change-of-law risk.

Multinationals choosing a country as a headquarters for
particular geographic regions or business functions (thereby
creating many significant high-value jobs) are far less likely to
choose Canada, since doing so creates tax risks and compliance
costs due to the FAD rules that simply don't exist in other
jurisdictions. Canada thereby risks becoming a "branch
plant" economy except to the extent of Canadian-controlled
enterprises, instead of a group hub for particular geographic
regions or business functions within a multinational group.

Foreign companies considering the purchase of a Canadian
corporation that owns significant foreign affiliates (even less
than the 75 percent threshold necessary to make the acquisition
itself an investment) may be willing to pay less than would
otherwise be the case, since they will essentially be incurring a
risk of double taxation and acquiring an ongoing Canadian tax
problem after making the acquisition due to the FAD rules.

As discussed below, foreign companies that do acquire
Canadian corporations will now have a strong tax bias to strip all
foreign subsidiaries out of the Canadian target to the greatest
degree possible, again reducing the Canadian operations to branch
plant status.

A. Inadequate Grandfathering Treatment

The fact that the charging provision does not differentiate
between investments in Foreigncos that were already Canco foreign
affiliates on March 28, 2012, and investments in new foreign
affiliates is a further example of its overreach. The result is to
penalize foreign multinationals that have chosen to locate foreign
group members under Canada for business reasons or that inherited a
"below Canada" foreign affiliate structure following the
direct or indirect acquisition of a Canadian corporation that had
foreign affiliates. It will now be dramatically more difficult to
manage the funding of these foreign affiliates going forward, and
there are no special accommodations offered for removing from under
Canada foreign affiliates that would not have been placed (or left)
under Canada had the FAD rules existed at that earlier time.

Transitional relief under the charging provision is very
limited. It applies to all transactions occurring after March 28,
2012, except transactions between arm's-length parties
that were the subject of a binding written agreement on or before
that date and that are completed by the end of 2012. Given the
magnitude of the FAD rules and the absence of any relief for
existing Canco foreign affiliates, it would certainly have been
desirable to allow multinational groups more time to consider the
implications of these rules and (when appropriate) restructure
foreign affiliates out from under Canadian group members. Indeed,
the Canadian Bar Association-Canadian Institute of Chartered
Accountants Joint Committee on Taxation (CBA-CICA Joint Committee)
has noted that there is no obvious reason for the 2012 completion
deadline for a transaction that is the subject of an otherwise
legally binding agreement, and further suggested that transitional
relief be extended to non-arm's-length transactions made to
consummate an arm's-length agreement that meets the
transitional relief rule.20

B. Arm's-Length Acquisitions of Canadian Corps.

Under the charging provision there is no business purpose test,
and arm's-length transactions are treated no differently than
intragroup investments. While these facts contribute to the
overbreadth of the charging provision in many ways, one of the most
serious is in the acquisition by foreign investors of Canadian
resident corporations owning foreign affiliates. While only the
acquisition of Canadian resident corporations whose assets are more
than 75 percent attributable to shares of foreign affiliates
constitutes an investment under the indirect acquisition element of
the investment definition, a broader problem exists on all
foreign acquisitions of Canadian corporations with foreign
affiliates, whether or not reaching the 75 percent
threshold.

At present, foreign purchasers of Canadian resident corporations
owning foreign affiliates essentially have three options for
dealing with those foreign affiliates post-acquisition:

Leave them in place under Canada.

Extract them from Canada by disposing of them to a foreign
group member (the potential for this generally depends on the
Canadian and foreign tax cost of disposing of the shares of the
relevant foreign affiliate).

Before the enactment of the FAD rules, many foreign acquirers
were content to choose option 1. Indeed, in some cases the
government requested (or insisted) that foreign acquirers make
Canada a regional or global headquarters for particular business
lines as a condition for approval of the acquisition, which would
typically involve leaving the Canadian target's relevant
foreign affiliates beneath it.21 Following the
introduction of the FAD rules, however, it will generally be much
more costly and inconvenient to leave existing foreign affiliates
"beneath" Canada, since the FAD rules will apply to any
subsequent investments made by the Canadian entity in its foreign
affiliates, even if occurring for perfectly legitimate business
reasons.22 This is so whether or not the initial
acquisition of the Canadian target was itself an investment under
the FAD rules, that is, whether foreign affiliate shares
exceeded 75 percent of the Canadian target's assets. As a
result, foreign acquirers will now have a much greater Canadian tax
incentive to pursue options 2 or 3 whenever possible, thereby
reducing the amount of activity in Canada relating to the
management, financing, and support of foreign affiliates. This
would not seem to be to Canada's economic benefit.

There is more, however. While options 2 and 3 will be available
as an alternative to option 1 in some circumstances (and indeed the
PUC reinstatement rule facilitates their use),23 the
fact is that in many cases they will not be. Option 2 is possible
in some circumstances without incurring unmanageable tax costs,
when (1) there is little or no Canadian tax on the accrued gains on
the foreign affiliate shares,24 and (2) the foreign
affiliate's home jurisdiction does not (or under an applicable
tax treaty cannot) tax those accrued gains. However, in a
significant number of cases this will not be the case; for
example:

the section 88(1)(d) ITA cost basis "bump" used to
eliminate accrued gains on the Canadian target's foreign
affiliate shares (and thereby Canadian tax on the disposition of
those shares) will generally not be available when, for example,
the foreign purchaser uses consideration other than cash to pay the
Canadian target's shareholders, or when some other technical
requirement of the cost basis bump is not met, as often occurs;
or

when the foreign affiliate shares derive their value primarily
from local real property (as will typically be the case in the real
estate, mining, and oil and gas sectors), the foreign
affiliate's home country will usually tax any accrued gain on
the disposition of the foreign affiliate's shares.

Similarly, because a corporate emigration involves a deemed fair
market value disposition of all of the Canadian resident
corporation's property and a notional dividend of its corporate
surplus, it generally is viable as an alternative to option 1 only
when the section 88(1)(d) cost basis bump is available, where its
property consists entirely of shares of foreign affiliates and
other "bump-eligible" property, and where the home
countries of its foreign affiliates do not treat the merger or
wind-up required to produce the "bump" as a taxable
transaction. As such, the practical result of including bona fide
business investments in foreign affiliates that have been acquired
on a previous arm's-length acquisition of a Canadian resident
corporation within the scope of the charging provision is that
foreign purchasers of Canadian corporations will generally either
(1) strip out of Canada as many foreign affiliates as they can to
the extent possible without significant tax costs, and (2) discount
the purchase price they are willing to pay to reflect the costs of
(1) and the costs of the Canadian tax problem they are thereby
inheriting under the FAD rules for all other foreign affiliates.
Both of these results seem adverse to Canada's interest, and it
is not apparent what offsetting benefit Canada is enjoying by not
excluding from the FAD rules transactions that are sourced from
arm's-length acquisitions and/or have no Canadian tax avoidance
motive.

C. Indirect Investments

The extension of the charging provision to include indirect
acquisitions (that is, acquisitions of Canadian corporations more
than 75 percent of whose property is shares of foreign affiliates)
is especially problematic. It is doubtful that such transactions
produce any material surplus stripping that the FAD rules are
stated to be directed at. Arm's-length acquisitions of Canadian
corporations owning foreign affiliates are invariably transactions
undertaken by the purchaser for business reasons, not to engage in
surplus stripping.25 As such, the benefits of including
an indirect acquisition element in the investment definition are
hard to see.

Including such indirect acquisitions as an investment greatly
increases the scope of the FAD rules, often (as noted by the
CBA-CICA Joint Committee) in completely inappropriate situations
when the transaction has no tax motivation and is simply a capital
markets or an ordinary-course business transaction.26
Foreign acquirers of a Canadian corporation that owns shares of
foreign affiliates representing more than 75 percent of the
Canadian corporation's assets (as often occurs in the natural
resources sector) will generally fall within this element of the
charging provision simply by following the standard (and completely
benign) practice of using a Canadian corporation (that is, a Canco)
to make the acquisition.

When the indirect acquisition rule may apply, one would expect
the foreign acquirer to price the transaction accordingly,
potentially discounting the price that it would otherwise be
willing to pay to reflect:

the risk of double taxation arising from the initial
acquisition, to the extent that the FAD rules produce either a
deemed dividend or a reduction of PUC that is not later reinstated
under the PUC reinstatement rule;

the same costs (Canadian and foreign) of extracting the
Canadian target's foreign affiliates out from under the
Canadian tax system, and ongoing costs of financing any Canadian
target foreign affiliates that do remain under Canada as apply to
all foreign acquirers of Canadian corporations with
foreign affiliates (described above in Section II.B); and

further adverse change-of-law risk.

Foreign investors choosing where to locate a headquarters or
holding company for foreign operations (in particular junior mining
companies) will often view an eventual takeover as a likely exit
strategy. As such, a Canadian tax issue that causes a potential
acquirer to pay less for the Canadian corporation will in turn make
it less likely that the initial investors choose to use a Canadian
corporation at the outset.

D. 'Series of Transactions'

The liberal use of the term "series of transactions"
to further broaden the charging provision is particularly
troubling. The result is that the general rule can apply when as
part of the relevant series Canco becomes controlled by
Parent or Foreignco becomes a foreign affiliate of Canco,
or when shares of a Canadian corporation have been acquired and as
part of the same series of transactions some of its property is
subsequently sold such that its remaining property is more than 75
percent attributable to shares of foreign affiliates. In other
contexts in the ITA, the term "series of transactions"
has been interpreted by Canadian courts quite broadly, to include
within a series of transactions a transaction that occurred either
before or after the other elements of the series, if the
parties "knew of the . . . series, such that it could be said
that they took it into account when deciding to complete the
transaction."27 The degree of linkage required
between two events to make them both part of the same series of
transactions is surprisingly low.28

As a result, it will be necessary for Canco to employ some
degree of clairvoyance when making its investment, if the basis for
concluding that the FAD rules do not apply is that Canco is not
controlled by a non-resident corporation or that Foreignco is not
at that time a foreign affiliate of Canco. If either of those
events occurs subsequent to the investment, the fact that such
subsequent event was not anticipated at the time of the investment
is not by itself enough to conclude that the subsequent
event is not part of the relevant series.29 As such, the
use of the "series" concept to expand the charging
provision to capture later events creates a significant degree of
uncertainty for taxpayers.30 No justification has been
put forward to explain why the government's policy objectives
require such a tenuous connection between the
"investment" and the related event. If an antiavoidance
measure is required to prevent multi-step transactions from
circumventing the FAD rules when they should apply, a much more
focused rule should be employed (as occurs elsewhere in the ITA and
the FAD rules).31

The author acknowledges with appreciation the thoughts of
Douglas McFadyen of Shearman & Sterling LLP in New York on the
subject of this article. However, any errors or omissions are
entirely the responsibility of the author.

2 That debt might arise directly as balance-of-sale owing
for the purchase price of the shares of the foreign affiliate or
debt incurred to fund the purchase price, or indirectly through an
increase in the paid-up capital of the shares of the Canadian
corporation (which allows increased cross-border intragroup
financing into Canada under Canada's thin capitalization
rules).

5 For example, the income imputation regime for amounts
owing by nonresidents includes an exemption for many controlled
foreign affiliates of the taxpayer (section 17(8) of the ITA), the
shareholder loan rules for amounts owing to a corporation from a
person "connected" to a shareholder exclude foreign
affiliates of the corporation (section 15(2.1) of the ITA), and
Canada's transfer pricing rules have special exclusions for
loans to (and guarantees of the debt of) most controlled foreign
affiliates of the taxpayer (sections 247(7) and 247(7.1) of the
ITA).

6 The rule does not apply when Parent is itself
controlled by a Canadian resident person that is not controlled by
a nonresident corporation. If there are multiple nonresident
corporations in the corporate chain "above" Canco, the
rules essentially deem the lowest-tier such nonresident corporation
to be the one that "controls" Canco, and to be the sole
"Parent."

7 Generally, Foreignco will be a foreign affiliate of
Canco if Canco has direct or indirect ownership of 10 percent or
more of any class of shares of Foreignco.

8 Subject to two exceptions discussed in Section III
below.

9 Other than debt, the direct acquisition of which is
excluded from these rules under the exceptions discussed in Section
III.

10 A Canadian corporation can generally make non-dividend
distributions on its shares as a tax-free return of capital to the
extent of the PUC of those shares. PUC is meant to represent
amounts invested in Canco as share capital by persons purchasing
newly issued shares from Canco, and so PUC returns constitute a
distribution of previously invested capital, not
profits.

11 Canada's thin capitalization rules apply to
restrict the amount of interest-deductible debt owing by a Canadian
resident corporation (Canco) to "specified
non-residents": nonresidents of Canada who either are 25-plus
percent shareholders of Canco (by votes or value) or do not deal at
arm's length with those 25- plus percent shareholders.
Currently, these rules prevent Canco from deducting interest
expense on debt owing to specified nonresidents that exceeds twice
the sum of (1) Canco's unconsolidated retained earnings at the
start of the taxation year, and (2) PUC attributable to Canco
shares owned by (and contributed surplus received from) a
nonresident 25-plus percent shareholder of Canco. This 2-1 ratio is
being changed to 1.5 to 1, effective 2013. See Steve
Suarez and Stephanie Wong, "Canadian Year- End Tax Planning
Deadlines for 2012," Tax Notes Int'l, Nov. 19,
2012, p. 747, Doc 2012-22478, or 2012 WTD
223-18.

12 A largely comparable PUC reinstatement also applies
for purposes of computing the departure tax applicable upon Canco
emigrating from Canada.

13 A further requirement exists regarding the
compensation and evaluation of such Canco officers.

14 See the explanatory notes to section 212.3 of
the ITA produced by the Department of Finance. These explanatory
notes do not constitute part of the legislation but rather are an
interpretational aid that a court may choose to consider in
interpreting it.

15 Such income might arise directly or as income earned
by Foreignco that is imputed to Canco under Canada's
anti-deferral (FAPI) rules, or when Foreignco uses funds from Canco
to make certain intragroup loans.

16 The "closest business connection" exemption
discussed in Section V, which is intended to allow for business
investments "down" the chain, is unworkable, complex, and
uncertain to the point of being of very little practical value for
most taxpayers.

17 Indeed, in the case of shares issued by Canco to a
third party in an arm's-length transaction, the adverse impact
of the rules' application is borne wholly or partly by the
third party, in terms of reduced PUC of the Canco shares they
acquire.

22 As discussed in Section V, while there is an exception
to the charging provision intended to allow for certain strategic
investments in Canco's foreign affiliates, this exception is
flawed to the point of being of very little practical
use.

23 Both options generally require that the Canadian
corporation's PUC be as high as possible.

24 In particular, when a foreign acquirer is able to use
the section 88(1)(d) cost basis bump described in Section IV, it
may be possible to eliminate accrued gains for Canadian tax
purposes on the shares of the Canadian target's top-tier
foreign affiliates.

27 Canada Trustco Mortgage Co. v. The Queen,
2005 SCC 54, at para. 26, available athttp://scc.lexum.org/en/2005/2005scc54/2005scc54.html.
The Supreme Court went on as follows: Section 248(10) extends the
meaning of "series of transactions" to include
"related transactions or events completed in contemplation of
the series". . . . We would elaborate that "in
contemplation" is read not in the sense of actual knowledge
but in the broader sense of "because of " or "in
relation to" the series. The phrase can be applied to events
either before or after the basic avoidance transaction found under
s. 245(3).

28 According to the Supreme Court of Canada in
Copthorne Holdings Ltd. v. The Queen, 2011 SCC 63, at
para. 46: a "strong nexus" is not necessary to meet the
series test set out in Trustco. The court is only required
to consider whether the series was taken into account when the
decision was made to undertake the related transaction in the sense
that it was done "in relation to" or "because of
" the series. Seehttp://scc.lexum.org/en/2011/2011scc63/2011scc63.html.

29 This was specifically decided by the Supreme Court of
Canada in Copthorne at para. 56:

The fact that the language of s. 248(10) allows either
prospective or retrospective connection of a related transaction to
a common law series and that such an interpretation accords with
the Parliamentary purpose, impels me to conclude that this
interpretation should be preferred to the interpretation advanced
by Copthorne.

30 Indeed, the fact that the FAD rules rely heavily on
the accompanying Explanatory Notes to explain what is meant and how
the rules are intended to operate further increases the
apprehension of taxpayers and their advisers.

31 See, for example, section 212.3(21) of the
ITA, which deems two persons not to be "related" to one
another for purposes of the corporate reorganization exemption if
one of the main purposes of a transaction or event is to cause them
to be related.

Another self styled educator with the Paradigm Education Group tax protester movement has been sentenced to a jail term for tax evasion and counselling others to evade as a result of a successful tax prosecution.

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